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Chapter 10Commercial Damages

CHAPTER SUMMARY

Overview

When harm comes to one person or party who suffers an economic loss as a result, there are financial considerations.If the loss is sustained from the harmful act of another, there may be damages. In a legal setting, the person harmed(plaintiff) and the person who harmed the plaintiff (defendant) may not agree as to the facts surrounding the harm andthe damages. Often experts are called in to resolve the issues and present them in court. The forensic accountant rolein such disputes can vary from case to case, but it is often concerned with the calculation of damages.

Commercial damages may relate to either loss of profits or the reduction in value of a business entity. In rarecases, there may be both lost profits and reduction in business value.

The Expert

110,001 Expert Witnesses' Qualifications

Sources differ on what qualifications are desirable for an expert witness in damages. Certainly, the expert shouldbe trained and experienced in quantitative analysis. According to the Federal Judicial Center's Reference Manual onScientific Evidence, the method used and the substance of the damages claim dictate specific areas of specializationthat experts need. The accountant who serves as expert witness will often be a CPA or hold a Ph.D. Often the accountantmay also have an MBA degree, and a growing number of practitioners are seeking a forensic-type credential.

1110,011 Expert Witnesses' Testimony RequirementsDaubert Factors. In the Daubert case, the U.S. Supreme Court characterized the Court's function as that of a

"gatekeeper" in determining whether an expert's testimony constitutes "scientific knowledge" that will assist the trierof fact to understand or determine a fact in issue. A judge performs this function by ensuring that an expert's testimonyis relevant and reliable. The Supreme Court in Kuhmo Tire Co. extended the principles of Daubert applicable toscientific experts to all experts possessing "technical" or "other specialized" knowledge.

Voir Dire Challenges. Voir dire (examination of witness's competency) is another legal obstacle to experttestimony in a damages case. Usually the opposing attorney is questioning the expert's skills, education, training,knowledge, and/or experience to be an expert witness.

Basics of Damages Litigation

110,021 The Legal Framework of DamagesIn order to win an award for damages, the injured party must generally prove two points: (1) that the other party

was liable for the damage, and (2) that the injured party suffered damages as the results of the actions or lack of actionsof the offending party. This usually requires the proof of three issues by the legal team: proximate cause, reasonablecertainty, and foreseeability.

Generally, the harm that has been caused by the plaintiff can be either a breach of contract or a tort. Thisdistinction is important in understanding the legal framework of damages and determining how they are calculated.

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1)10,031 Two Types of Harm: Tort and Breach of Contract

Two types of harm are the focus of damages awards. As mentioned in the Overview, one type of harm is a tort,or an act that is harmful in itself. The second type of harm is a breach of contract, which is a failure to fulfill one'scontractual obligations.

Generally, torts leading to economic loss can involve personal injury, wrongful death, and commercial damages.In personal injury cases and wrongful death, damages assessment is somewhat straightforward. It is in commercialdamages cases, where expert testimony is most often complex and driven by unique circumstances.

f 10,041 Two Types of Damages: Restitution and Reliance

Two types of damages must be understood in loss studies. Damages from a tort are determined under theprinciple that compensation should place the plaintiff in a position economically equivalent to that person's positionabsent the harm. When the harmful act unjustly enriches the defendant at the expense of the plaintiff, the termrestitution is used to describe the damages. When the harmful act is fraud and the intent of damages is to restore theplaintiff to the position as if no promises had been made, the damages are described as reliance.

When an expert witness provides a damages estimate in a dispute, he or she typically makes many calculations,using accounting assumptions and accounting measurements in arriving at the damages estimate. But damages estimatesare different from most accounting reports. Most of these accounting reports are based on historical data. Forensicanalyses typically are quite different from traditional accounting and reporting activities because two different expertsmay look at fundamentally the same accounting data and each may see the damages in a different way.

Approaches to Loss Estimation

1)10,051 Damages Calculation Approaches

Two major theories are used to determine damages; the one selected depends upon state laws. The theories arethe out-of-pocket method and the benefit-of-the-bargain method. The out-of-pocket loss (California and New York)refers to the difference between the actual value received and the actual value conveyed. Under the benefit-of-the-bargain theory (or expectations remedy), the damages include not only the money invested but also other expensessuch as increased costs (i.e., interest expense), lost profits, and decreased value of the investment.

110,061 The Lost Profits Methods

There are three major methods to calculate lost profits: before-and-after method, yardstick approach, and the"but-for" method. In addition, the direct method and the combination method are also available to the analyst.

110,071 Study of Losses Process

When an economic loss takes place and damages need to be applied in an established legal framework, a "studyof losses" is made. The primary elements in such a study are the quantification of the reduction in earnings, thecalculation of interest on past losses, and the application of financial discounting to future losses. In most situations,current and future earnings of the plaintiff are measured against estimates of current and future earnings that wouldhave been received by the plaintiff had the harmful event not occurred. Interest on the losses occurring before the trialare also calculated and future losses are often calculated and discounted.

1)10,081 Economic Framework for the Lost Profits Estimation Process

Not unlike a business valuation, a damages projection must include an economic analysis of the macroeconomic,industry, and company environments.

Macroeconomic Analysis. First, an analysis of the economy is made looking at measures of overall economicperformance. Gross domestic product (GDP) is one measure of economic activity that is often used for such purposes.Often, the macroeconomic analysis will drill down further to look at regional performance as well.

Industry Analysis. Industry analysis is the next level of economic analysis performed. A specific industry maygrow with the macroeconomic trends, or it may not, A specific industry may experience its own peaks and valleys. Anindustry analysis looks at the industry's recent performance, its current status, and outlook.

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Company-Specific Analysis. After the accountant looks at the macroeconomic conditions and the industryconditions, a company-specific analysis is needed. This analysis will include scrutinizing the financial statements.This step may well involve a fraud audit type review if circumstances call for it. Case-specific data also will begathered and financial ratio analysis may be needed to further ascertain the health of the company under study.

Financial Analysis Conclusion. After reviewing the economic conditions and performance from amacroeconomic, industry, and company-specific vantage point, the expert is ready to draw some conclusions.

Measuring the Loss

110,091 Length of the Loss Period

The period of time in which losses are measured is important. Losses must be measured over the time period inwhich sales recover from the wrongful harm. Denning the loss period is the starting point for the loss measurementprocess. To define the loss period requires a determination of what type of loss period is involved with the damagesclaim. It might be a "closed" period, in which revenue declines and has already recovered. It might be an "open"period during which revenue losses continue. Or it might be an "infinite" period in which the firm has gone out ofbusiness.

Projecting Lost Revenues. Next, the expert projects lost incremental revenues and applies a profit margin tothe projected lost revenues. The profit margin should reflect all of the incremental costs that would have been incurredto achieve the forecasted incremental revenues. Lost revenue projection can be obtained using simple methods orsophisticated ones.

Measuring Profitability. Forecasting revenues is not the same thing as forecasting profitability. True economiclosses are lost incremental revenues minus lost incremental costs. The margin associated with these lost incrementalrevenues is usually equal to, or less than, the gross margin but greater than, or equal to, the net margin.

Mitigation and Offsetting Profits. Lost profit analysis also must consider mitigation and offsetting profits. Aplaintiff needs to have taken reasonable steps to mitigate or reduce its damages. If reasonable steps are not taken, thedefendant may argue successfully that the damages should be reduced accordingly. A company may be able to adjustits activities so that profits lost in the harmed business segment were made up for by increases in another segment thatwere the result of juggling redirected assets or capacity from the harmed segment. The defendant might successfullyargue that damages should be reduced.

Time Value of Money Considerations. Accounting students understand the time value of money. In determiningdamage awards, consideration is given to economic loss that has taken place prior to the trial and loss that will takeplace after trial.

•010,101 Components of Damages

A 1986 AICPA publication lists the following possible types of damages: lost profits, lost value, lost cash flows,lost revenue, and extra costs. This list is not exhaustive; often more than one of these elements will be part of the finaldamages estimate. Clearly, accounting data would typically be of value in making the damages estimates, but somecomponents of the damages estimate are not available from the accounting records.

110,111 The Defendant's Damages Estimate

The following sections flfl 0,111-fl 0,161) refer to the information in Example 10.2. For purposes of thesesummaries, only general ideas will be included.

In order to arrive at a "zero" damages estimate, a defendant must demonstrate to the court that the plaintiffsuffered no financial damages. If there is no data supporting the previous scenario, the expert for the defendant wouldattempt to minimize the damages. The defendant's expert report would include his or her damages estimate along withsupport for the numbers presented.

The defendant's expert from Example 10.2 calculates a damages estimate.

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1)10,121 The Plaintiff's Damages Estimate

Damages estimates are both an art and a science. The scientific part is primarily the understanding and appropriateuse of accounting information. The art part of the process is in knowing how the accounting information is used increating components of the damages estimate.

In addition, expert witnesses frequently use many other kinds of information other than traditional accountingrecords in arriving at and defending damages calculations. The more unbiased the supporting information, the betterthe expert can support his or her expert report.

The plaintiff's expert from Example 10.2 looks at what to consider in damages calculations.

110,131 Lost Sales and Profits

The plaintiff's expert from Example 10.2 makes an analysis on lost sales and profits.

110,141 Production or Other Cost IncreasesThe plaintiff's expert from Example 10.2 identifies four areas of cost increase resulting from the contract tort:

lumber supply, labor cost, shipping cost, and advertising cost.

110,151 Customer III Will and Future Lost ProfitsThe plaintiff's expert from Example 10.2 conducts an analysis of customer ill will and future lost profits.

110,161 Other Adverse EffectsContract torts and other causes of action in litigation can give rise to a wide variety of alleged damages in a

particular situation. Whenever possible, the expert witness for the plaintiff will be asked to provide support for theplaintiff's positions on damages issues. Other times there may be some facts alleged by the plaintiff that are notaccurate, logical, or defendable. Experts must use experience, wisdom, and common sense in sorting through damagesallegations. The various components of the expert's damages estimate are combined into a total damages estimate thatcomposes a major part of the expert report.

The total damages estimate for the plaintiff from Example 10.2 is shown in Figure 10.2.

The Expert's Journey Through the Legal System

110,171 Testimony Early in CasePretrial Summary Judgments. Often the information and opinions provided by accounting experts will result

in a settlement before the dispute goes to trial or even a verdict. Attorneys may file a petition for summary judgment,which implores the court to side with them immediately and throw out the arguments of the other side.

Decision to Try the Case. When a summary judgment is not granted, and there is no pretrial settlement bythe litigating parties, the dispute then goes to trial. The arguments of the attorneys, the fact witnesses, and the expertwitnesses are heard by the court.

As in the earlier example, often there are significant differences between the damages estimates expressed byboth sides. The court must decide who is correct or what the appropriate middle ground is between the two positionstaken by the experts.

110,181 Defending the Expert ReportDeposition Testimony. Typically, the expert has to testify twice about the expert report submitted. The first time

is deposition testimony when the expert is questioned, under oath, about many issues. The questioner, who is one ormore attorneys for the other side, attempts to learn as much as possible about the report and how it was developed.The main purpose of the deposition is to find "flaws" and weaknesses in the expert report.

Trial Testimony. Deposition testimony occurs during the discovery phase of the damages litigation. If theconflict is not settled out of court, the trial phase is next. At trial, the expert may testify again about his or her expertreport, assuming there is no successful Daubert challenge.

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Questioning by Client's Attorney. Unlike deposition testimony, the first questioner at trial probably will bethe expert's attorney. The objective of the accountant's testimony and of the attorney's questions is to present theaccountant's side of the conflict as it relates to his or her expertise. The friendly attorney wants the expert to appearas a knowledgeable and believable expert witness. The attorney also wants testimony about the expert report to bepersuasive to the judge and/or jury in evaluating the issues in the dispute.

Questioning by Opposing Attorney. Once the friendly attorney has finished questions about the expert report,one or more opposing attorneys will cross-examine the expert. The objective of the opposing attorneys is the opposite:to discredit the witness as an expert and to discredit the expert report.

Preparation for Trial Testimony as Essential. Trial testimony is the accountant's chance as an expert witnessto influence the outcome of the trial for his or her client. The expert's ability to articulate his or her positions in thedispute to the court is crucial. Trial testimony is usually much shorter than deposition testimony.

Rebuttal Testimony. In addition to preparing and submitting an expert report, the defendant's expert probablywill be asked to provide insight and support for evaluating the other expert report and testimony of the plaintiff'sexpert. Usually, the opposing expert is asked to act as a rebuttal witness against the plaintiff's expert report andtestimony. Sometimes rebuttal testimony is more valuable than direct testimony.

Cost Behavior and Damages CalculationsVirtually all damages calculations performed by accounting experts require the use of cost behavior concepts

and the estimation of cost behavior patterns for relevant accounting data in the dispute.

110,191 Cost Behavior Defined

In its simplest form, cost behavior is the way that cost(s) change with respect to changes in the volume ofactivity. Notice that there are two components to the definition of cost behavior. The first is a change in the cost andthe second is with respect to some change in the volume of activity.

flO/201 Common Types of Cost Behavior

Fixed costs fundamentally are not driven by changes in the volume of activity. Variable costs change directlyand proportionately with the volume of activity. Mixed (or semivariable) costs are costs or cost pools that containboth a fixed and a variable component. Semivariable costs change with the volume of activity, but not proportionatelywith activity changes. Costs of this nature are often called learning curve costs because they increase at a decreasingrate with the volume of activity. Semifixed costs increase in steps or jumps. Some argue that all fixed costs are reallysemifixed costs at various levels of activities.

1)10,211 Cost Behavior Assumptions

Basis of Cost Behavior Estimates. Two basic assumptions underlie the concept of cost behavior. They arethe relevant range assumptions and the time assumption. Although it is convenient to think of costs as being fixed,variable, mixed, or something else, few costs exhibit the same cost behavior pattern for all levels of activity. Instead,costs exhibit a particular cost pattern for a specified range of activity called the relevant range. Cost behavior estimatesare usually based on historical cost observations and analyses.

A second important cost behavior assumption is the time assumption, which means that as time passes, thebusiness environment changes, and cost behavior may change as well. Many factors can cause a cost to changepatterns over time.

Ways of Estimating Cost Behavior. There are several ways of estimating cost behavior: account analysismethod, high-low method, regression analysis, and engineering or work-measurement method.

Account Analysis Method. The account analysis method classifies the cost accounts in the subsidiary ledger asfixed, variable, etc., based upon experience and judgment. This method is cheap, but subjective.

High-Low Method. The high-low method is the simplest quantitative analysis based upon the basic formulay =• a + bx, where b is the unit variable cost per measure of activity.

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Regression Analysis. Regression analysis takes all available data and estimates the cost function. That is, thisstatistical analysis determines the average amount of the change in the dependent variable by using all available data.

Engineering (Work-Measurement) Method. The engineering or work-measurement method uses industrialengineering, which can be expensive.

1)10,221 Damages Period and Discount RateBecause the largest component of a plaintiffs dispute is the future years' lost sales and profits, the future

damages period is important (e.g., after trial). The longer the damages period, the more difficult to establish that anylost profits relate to the harmful event. Besides, a plaintiff must take whatever steps or actions necessary to overcomeor mitigate any damages. The longer the recover)' period, the more likely the lost profits result from the plaintiff'sfailure to mitigate the damages or some other irrelevant factor.

Discounting After-Trial Damages. The after-trial damages should be discounted back to present value. Thereare two major approaches to discount amounts to present values. One approach is to project a plaintiff's hoped-forincome stream, by modifying losses to a realistic expectation by factoring in future losses to a present value at a risk-reduced relatively low discount rate. Another approach is to project the hoped-for-but-lost amounts and then apply ahigher discount rate that already includes risk or uncertainty in order to determine the present value.

Case Law for Discounts. Generally, the courts will not approve a discount rate above 20 percent. Some courtdecisions that involve discounts are listed in f 10,221.

110,231 ConclusionCalculating commercial damages represents another legal and accounting touch-point where the knowledge,

skills, and abilities of the accountant are put to good use in a forensic context. The complexity of the process isapparent to those who must understand the legal and accounting concepts, the various calculation methods and theeconomic framework. Measuring commercial loss can involve practically all the complexities of business valuation.Thus it should only be undertaken by those practitioners trained in the requisite competencies of the valuationexpert. Forensic accountants need to understand the fundamentals regardless of whether they intend to take on suchengagements because, like business valuation, damage calculations will enter into the forensic fray in many differentcircumstances involving the forensic specialist.